The relative strength index is a very useful tool to help us spot extreme conditions where a quick snap back occurs. I like to use the RSI to help me uncover extremely overbought or oversold stocks. While the stochastics is useful to spot overbought oversold areas, the RSI can be used to discover extreme moves which can give us a quick reversal trading opportunity.
The rules of interpretation for the RSI is as follows:
I use stockcharts.com to create a chart with RSI.
In the chart above you can see AES with the RSI indicator at the top and the stochastics indicator below. I have found that the RSI is not very useful in pointing short term overbought oversold conditions. If you follow the RSI strictly, you will probably miss out on a lot of trades.
I found that the slow stochastics is more useful and accurate in spotting short term overbought oversold conditions.
Although the RSI does not work as good as the stochastics in spotting short term overbought oversold conditions, I found that the RSI is very good at spotting extreme moves which might produce a quick snap back.
In the chart above, you can see how ADM had a big move up in November. The RSI moved to an extreme overbought level and formed some dark area. If you were holding this stock, you should be extremely cautious. Notice how a few days later, this stock had a sharp reversal to the downside.
The chart above shows DRYS had a quick unbelievable run up in November. However, the RSI was showing an extremely overbought level that was unsustainable. Look how fast the stock snapped back and reversed to the downside.
The chart above shows how AGN had a severe crash in late October to early November. The RSI went to extreme oversold levels. Notice how the stock quickly snapped back up. There was an extreme overbought level that formed in the RSI in early 2017. The stock ignored the reading and did not fall that much.
As with all indicators, they do not work all the time. You need to put into consideration other technical analysis concepts. The explanation of why the RSI did not work at the time is that the snap back up in November had already absorbed the sellers. The rounded bottom formed in December shows a bottoming process and buyers have already stepped in around late December. The stock has started a new uptrend and therefore the overbought reading did not work.
If all these sounds complicated, don't worry.
As you progress through this whole course you will understand the other technical concepts which will aid your analysis.
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